How to Pay off Debt: Lowest Balance or Highest Interest First?

When it comes to debt, which is better – paying off the highest interest debts first or the ones with the lowest balance? My answer on how to pay off debt may surprise you.

When I meet with someone as a financial coach, one of the first assignments I give is a debt list. This includes the amount owed, name of the card, company or individual owed and the interest rate.

When people bring their debt list to our first meeting, it would be easy to explain that mathematically it would make the most sense to to pay of the highest interest debts first. Yet this is what I think.

What matters more is what it will take to motivate that individual.

So, instead of telling them what I think they should do, I explain the different ways of paying down debt and the advantages to each. Then I ask them which one they think would work best in their situation.

Occasionally someone will ask me what I would do. If they ask, I tell them. Much like I might ask my Doctor what he would do if faced with the same medical choices I was facing. More often than not, people will find that one suits their personality better. They’ve seen their list. They know the total damage and usually one of the potential ways of paying down debt is more attractive than the others.

Here are some common ways to pay down debt:

1) Highest Interest First

This system makes the most mathematical sense. The faster the highest interest loans are paid down, the more funds there are to apply towards the rest of the debt. My experience is that left brain analytical, logical, linear thinking people generally prefer this method.

2) Pay off the lowest balance first.

Pay off the smallest debt first and work towards the largest debt regardless of interest. This system makes the most psychological sense. It’s very motivating to see the debt paid off quickly. Much like Pavlov’s dog returning to his food dish every time the bell rings, some people are highly motivated by watching their debts disappear. As the lowest balance debts are paid off and crossed out, motivation to continue to pay of the debt increases. My experience has shown that right brained, creative, non-linear thinkers often prefer this method.

3) Debt Consolidation

This might include putting all debts on a line of credit, home equity loan or a 0% credit card transfer. Some people prefer to take all of their debts and consolidate them to one large loan. This is what we did at the beginning of our financial journey.

The risk with this type of debt repayment is that suddenly the person has a pile of credit cards that are free and clear with zero balance. Unless they are willing not use credit at all until the debt is paid down, it has the potential to drive them deeper into debt. This system has the advantage of having a lower interest rate then is generally available on credit cards or department store cards.

Debt consolidation often works well for someone who is committed to get out and stay of of debt and for those who are simply overwhelmed with their lists of debts, minimum payments, due dates and keeping it all straight. It’s the ideal system for for those who feel overwhelmed by their list of debts or for naturally disorganized person.

I’ve heard many a financial writer debate which system they feel is best. Suze Orman argues strongly for the highest interest loans first while Dave Ramsey argues it should be the lowest balance first. In truth, the best system is the one that works for the person who finds themselves with a list of debts they want to pay off.

Which system did you use to get out of debt?

Kathryn works in public relations and training for a non profit. In her off hours, she volunteers as a financial coach helping ordinary Canadians with the basics of money management. Her passions include personal finance and adult education. Kathryn, along with her husband and two children live in Ontario.

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About the author: Kathryn has been a staff writer for MDJ since January 2009. During the day she works in an office. In her off hours, she volunteers as a financial coach helping ordinary Canadians with the basics of money management. Kathryn, along with her husband and two children live in Ontario.

There’s an additional option not mentioned above- focus on paying off the debt that annoys you the most! Much like paying off the smallest debts first, it’s based on emotion rather than math. For me, this meant focusing on paying off my student line of credit first, then focusing on my mortgage. It may not be the most efficient way to deal with debt, but it feels good!

My debt repayment is kinda weird: my lowest balance has the highest interest rate!
Back when I started, though, I did have some smaller debts kicking around. I know I’m the type of person who enjoys instant gratification, so as soon as I could I paid all those little ones off (my tax return played a big part in that). Now I’m left with a system that has no one “optimal way”, either financially or psychologically, but since I got that kickstart I’ve been able to stay motivated. When I started paying things down, I cut my credit limits so I would be unable to dig myself back in even if I was somehow really tempted to. I didn’t think that would happen, but I did not want to leave the possibility open.

I really appreciate how this information is presented. It doesn’t tell you what the best way (in the author’s opinion) is but gives us options and information so that we can choose. I’m sure that seeing all of the options in one place helps all of us pick out the one that is right for us.

Thanks for believing that we have a brain and allowing us the opportunity to use it.

I don’t have any debt (yet) but i’ve been helping my partner pay down his. I’m with the system that MoneyGrubbingLawyer suggested – the one that annoys you the most. My partner has a loan with Wells Fargo (scam artists) that constantly harass him to take out more cash, harass him if his payment is due the next day, etc etc. To get them off our backs would be LOVELY, so we’ve been paying that down and will be rid of it in a couple weeks! Definetely a good motivation booster.

Next is the income tax tho – the biggest and scariest of them all. My partner owns his own (small) company, income tax is a tricky beast when you’re trying to estimate it.

There’s another factor that I also used when paying off debt: which one has the worst effect on my credit score while in repayment?

My husband and I had a combination of government student loans, an open student LOC (read revolving account) and an older, closed student LOC. The government loan had the highest interest rate (by a little), the closed LOC the biggest balance, but we paid the open LOC off first so that we could close that revolving credit account sooner. After that we moved onto the highest interest rate account.

NoDebtGuy: That skit is a classic. It’s my all time favourite SNL skit.

FT: Good point about the debt consolidation changing credit score. This should be considered in the overall picture.

MGL: Very true about the most annoying one. I may have to add that to my list!

Cailin: Instant gratification really helps! I’ve seen a number of people kick start their plan with a tax refund! Only you know yourself well enough to know what would work and what wouldn’t work. It’s great that you took the initiative to cut your credit limits as a way to restrict yourself knowing this was something you needed.

Digger: Thanks. One of my passions is adult education and training. One of the main themes that comes out of adult education is respect for the adult learner. Many of the people I work with are significantly brighter than I am. My role is to get them thinking and use the knowledge they already have. It’s not about telling them what to do. It’s about helping them discover how to do it themselves.

M Hawk: Owed income tax would be at the top of my annoying list too. Best of luck to your partner working off his debts.

I would pay off the debt that is psychologically most draining (or most annoying, like other posters have said). I once owed money to my father-in-law, he charged me zero interest but his was the debt I paid first once I had a decent income, then I paid credit cards (highest interest) then my student loans (highest dollar amount).

I think owing money to family members is poisonous, and should be avoided at all costs, unless you have a formal arrangement for repayment.

As a person working in the financial industry it was my hope to pay off the highest interest debt first as I understood that even with the deductibility of the student loan interest accounted for, I am still getting hosed.

That said, when my wife and I came up with a plan we agreed that the actual interest rate would be the secondary factor in deciding which debt is paid off first. The primary choice would be the loan with the highest monthly minimum payment. My wife liked the idea of freeing up cashflow as quickly as possible for any unexpected happenings. With a little bit of fighting I convinced her that while we may pay off the loan, the monthly payment should be tacked on to the next targeted debt. That way my wife gets to feel the satisfaction of paying off a loan, and I get to tell myself that the additional minimum payments while I save up for the lump sum pay down are saving me interest. We also confirmed that we can reset to the minimum payment at any time if we need the cash flow, which still gives my wife the flexibility she wants.

I typically don’t have debt (other than the mortgage) but I would look at which is the highest effective AFTER TAX interest rate. I have a tax deductible HELOC which is higher than my mortgage, but not when tax is factored in. Thus, my focus is on paying down the mortgage.

I can understand the psychology of the approach to pay down smaller debts first so that some personal satisfaction is achieved through goal accomplishment.

cannon_fodder: i agree with you that paying the high interest is the way to go, but for all might not be “the most financially sound method.” If a person pays off the smaller balance, lower interest debt first as opposed to paying a larger higher-interest debt but then loses hope as the number of loans is the same, THAT should also be considered financially sound.

Good article – I agree with everyone here – it’s best to pay off the highest interest first. Also if you have the money to pay something off rt away – you should just pay off the balance in full – this looks good on your credit history.

Going with what FT said – if you consolidate your credit cards – it may lower your credit score but if you’re responsible your credit score will rebound pretty fast. Especially with a lower interest you can pay more of the principal off. But if you just pay the minimum there is a flag on your credit score that says you’re just paying the minimum. If you know you have to consolidate you should – which will be good for you, but if you consolidate over and over again that’s not a good sign.

What most people don’t realize is that one of the factors taken into account when calculating your credit rating is not just your total debt but also your balance in relation to your maximum. that means that if you are within 75% of your loan maximum or credit card limit, it counts as a black mark on your rating. So if you pay off your highest interest debt while leaving lower interest debts near your max, your actually worse off from a credit rating standpoint.

This is a great article! I agree that the three approaches mentioned are the most common in paying off the debt. It is very important for a person to choose what method works well for their lifestyle and current financial standing. Having a budget and sticking by it is also vital in ensuring that further debt is not accumulated.

A number of years back I was in really poor financial health. I had a bunch of bad credit cards, and a line of credit racked up. When I was in a position to start repaying them, I decided on a set minimum I would pay to each debt (in the neighbourhood of 3% of the then outstanding balance). That was the minimum amount I would pay towards that debt each month until it was paid off. Any extra money went to the debt with the highest interest rate. As each debt got paid off, it’s minimum was added onto the debt with the next-highest interest rate.

The most Important thing is a plan that allows the client to stay motivated. You cant go from Visa rich to re-using coffee filters overnight. A realistic, incramental plan is best.

One comment for people looking at the consolidation option would be to take a ooan option vs the Line of credit. The main reason for this is to have a set structured monthly payment with an end date in site. Thats a motivation piece. Most lender wont Amm more than 36 months on a consolidation but if you can stretch to 48 or 60 months thats an option to keep the required payment down. One trick I do for clients is setup a loan payment that fits their budget and keeps their ability to spend in check but give them a payment amount that will pay off their loan faster. They can speed up their payment schedule as much as possible but still have the required payment there in case they fall off the wagon and will still be debt free in XX months. I, depending on the client, will require closure of credit facilities I am re-writing and leave minimal cash flow credit available to minimize racking up more debt.

Consolidation lines of credit are a credit card with a better rate. You put money on em and take more out.

I think for a lot of people, especially those who have problems with debt, attacking debt is like attacking a mess in their house. If the entire house is a mess, it can be so daunting, they do nothing about it. However, if they just start small, room by room, they will see how good one room looks and be motivated to finish the rest.

And therein is the key: motivatation. For those who have issues with debt, I believe paying the smaller debts can be more motivating.

This is a very good article, and it is a very good idea to contrast what seems to be the two main competing debt repayment ideologies. I really believe that there is no one right answer that is right for everyone. I agree with the people that are suggesting that you should do whats right for you. Although paying down the high interest rate makes mathematical sense, that doesn’t necessarily work for everyone. Many people need the little kick that comes from having a few small victories along the way.

That’s actually very interesting and true – once you’re able to pay off a debt fast it does motivate you more. And even more so when you know your credit score got a big boost from it. Last December my credit score was only at 680 and now it’s at 765 after I got it checked for an auto loan. :)

Our mortgage is at 6% and carrying PMI but we decided to knock out a 5k student loan at 4.25% to increase our cash flow and accomplish something. Since we still need 22k to ditch the PMI we discovered last month that we hit the number of months of consecutive repayment early with our overpayments on the student loan and they dropped the interest rate.

Therefore there are sometimes benefits within your debt situation to also be considered. We will throw 1500 at the other student loan to knock its interest rate down before eliminating PMI on the mortgage.

For me it has always been pay of the highest interest rate first. I disagree on points two, because I find it very likely that the people who do the wrong things, even for motivational purposes have not learned their lesson. Furthermore, by paying off the smallest balance first, the monthly minimum payments won’t drop by much versus paying the highest interest first.

The correct thing to do is step number one. Anything else is irrational and is exactly why we are in a financial mess to begin with!

There are more factors involved in debt payback than just interest rate and lowest balance. People forget about the term (how many months left). People forget about the TYPE of interest rate- fixed or variable. People forget about the TYPE of debt- closed end (like a mortgage) or open ended (like a credit card). All of these factors are involved in debt payback. They ALL have to be taken into consideration when deciding which debt gets your extra payment. Don’t just fall victim to “highest interest rate” or “lowest balance.” There is more to this than meets the eye. Think carefully.

I think the three options you are offering are brilliant. If you were my financial coach I would find your approach very helpful. These 3 choices allow the indebted person to find what resonates most with them and what suits their personality. I would choose the option of debt consolidation. I am the type of guy who is committed to pay off and stay out of debt.

My wife and I also consolidated our debt onto a 0% interest card for 12 months. The 3% fee of the amount transferred was much less than the overall interest we would have paid, plus we weren’t getting charge interest every month. This gave us time to ‘catch up’. But as you said, its important to do something with all of those cards with zero balances. We cut all of them up but 1. This kept us from going into debt while we were paying down our other debts.

The question from Jean, if you want to increase your credit score, I believe paying down the debts on the cards with the highest balance would benefit you more. One of the key credit scores looks at ‘how much debt versus how much debt you can have on a card’. If you are over the 30% mark on one credit card, it will eventually lower your score. Meaning, if you have a credit card with a limit of $10,000, you can charge up to $3,000 on the card before it starts to negatively affect your score. This was an issue we had to deal with and saw an improvement to our scores once we paid down our debt.

Hi. Thanks for your reply. I guess what I am trying to figure out is should I pay the higher balance with the lower interest rate first to try and reduce the rate of the compounding interest because it’s so high or does the higher rate lower balance need the attention first because it’s accruing faster at a higher rate? I guess you have already answered that but I didn’t really understand, I understand the explanation but not sure as to what the answer is. Thanks.